Question

Sound Systems has 200 shares of common stock outstanding at a market price of $37 a share. The firm recently paid an annual dividend in the amount of $1.20 per share and has a dividend growth rate of 4 percent. The firm also has 5 bonds outstanding with a face value of $1,000 per bond that are selling at 99 percent of par. The bonds have a coupon rate of 6 percent and a yield to maturity of 6.7 percent. All interest is tax deductible. If the tax rate is 21 percent, what is the weighted average cost of capital?

1. 5.93

2. 6.87

3. 6.37

4. 6.54

Answer 1

Market Value of Capital Structure

Market Value of Debt = $4,950 [5 Bonds x ($1,000 x 99%)]

Market Value of Equity = $7,400 [200 Shares x $37 per share]

Total Market Value = $12,350

After-Tax Cost of Debt

After Tax Cost of Debt = Yield to maturity x (1 – Tax Rate)

= 6.70% x (1 – 0.21)

= 6.70% x 0.79

= 5.29%

Cost of Common Equity

Dividend in year 0 (D0) = $1.20 per share

Current selling price per share (P0) = $37.00 per share

Dividend growth Rate (g) = 4.70% per year

Therefore, the Cost of Equity = [D0(1 + g) / P0] + g

= [$1.20(1 + 0.04) / $37.00] + 0.04

= [$1.2480 / $37.00] + 0.04

= 0.0337 + 0.04

= 0.0737 or

= 7.37%

Weighted Average Cost of Capital (WACC)

Weighted Average Cost of Capital (WACC) = [After Tax Cost of Debt x Weight of Debt] + [Cost of equity x Weight of Equity]

= [5.29% x ($4,950 / $12,350)] + [7.37% x (7,400 / $12,350)]

= [5.29% x 0.4008] + [7.37% x .5992]

= 2.12% + 4.42%

= 6.54%

“Hence, the Weighted Average Cost of Capital (WACC) will be 6.54%”